Ahead of the Curve

The lending environment is undergoing a worrying change. Funds that European direct lenders have raised but not yet deployed are at an all-time high and banks in most Western-European jurisdictions have renewed lending following years of reticence after the global financial crisis, leading to increased competition amongst lenders in the small and medium enterprise (SME) market.

Top 1000 Pension Funds: A two-way street

The cabinet’s endorsement of FTK2 means important decisions for Dutch pension funds and social partners, according to Nina Röhrbein, with risk shifting to members

The pension fund industry in the Netherlands will undergo significant changes after details for the new financial assessment framework (FTK2), were revealed in July 2013, following agreement by the cabinet.

Under the FTK2, the financial risks for pensions are shifting away from the employer and the pension institution towards the individual members.

Defined benefit (DB) pension funds will have to choose between a nominal framework with high levels of guarantee, and a real contract, which offers annual price indexation. While the latter is a longer-term framework with a specific ambition to compensate for inflation, benefits are conditional and linked to the returns of the respective pension fund.

A 101% solvency ratio is required in the real contract. With the help of an adjustment mechanism for financial shocks (AFS), pension funds with real contracts will be able to handle financial market crashes and changes in longevity. In case of underfunding, they can spread their recovery over a maximum period of 10 years.

Nominal contracts have three years to recover. For the nominal contract, additional buffers are required to ensure that a certainty level of 97.5% can be maintained.

But with the buffer level set higher by the new framework than probably achievable over that time, they will most likely have to adjust their asset allocation to lower their buffer requirements.

As they are required to increase their buffer reserves and, depending on their individual investment strategy, to de-risk and lock in the nominal benefits, pension funds with a nominal contract are likely to invest defensively, while those with a real contract are expected to invest in index-linked bonds and other inflation-linked assets, such as real estate and infrastructure.

Whenever a real scheme falls into underfunding, rights cuts – cuts to indexation or benefits – will have to be applied. As a result, in the real framework benefit cuts are expected to occur more frequently but to be smaller in size.

Benefit cuts have already affected many pension funds.

In April 2013, around 70 pension funds were said to have cut their pension benefits by 0.5% to 7%, affecting more than one million pensioners and more than two million active members.

Currently, legal agreement of participants and retirees is necessary to move accrued rights into the new contract. Having the accrued rights in an old contract and the new rights in a new contract will lead to more complex administration, but the issue is said not to be entirely resolved yet.

A hybrid between the nominal and the real contract is also being discussed. Pension funds have until late September to respond to the consultation document. The final version is expected to be unveiled at the end of the year, with the new framework coming into force on 1 January 2015.

As part of the new framework, an ultimate forward rate (UFR) was introduced in autumn 2012 to discount pension liabilities.

For the average DB pension, the UFR increases funding status and decreases regulatory market risk, because the long end of the curve is tied to the UFR. For now, it remains at 4.2%.

As part of the efforts to increase professionalism and consolidate the large number of pension funds in the Dutch pension market, a new governance law came into effect on 1 July 2013.

It requires funds to choose between five governance structures. Three are paritarian – dualistic or joint paritarian, mixed paritarian and reverse mixed paritarian – and two independent options – dualistic independent and mixed independent.

Independent means that the board consists of external board members who set the strategy, while the paritarian models represent employees, employers and retirees on the board.

The new system replaces the old, which required only employee and employer representatives on the board. Pension funds have one year to change their governance and the structure of their board.

Industry-wide pension funds will also have to set up a supervisory board, the RvT. This board monitors processes and risk control and only has approval rights, for example, for the remuneration policy of the directors and the annual report. Until now most pension funds have used visitation committees, which visit ad hoc every couple of years to scrutinise the functioning of the board of trustees.

In an attempt to improve the country’s deficit, the Dutch coalition government introduced new tax legislation, which significantly decreases the tax incentives for pensions.

For DB pensions, the maximum accrual rates for average salary schemes will be lowered from 2.25% to 2.15% as of 1 January 2014. The DC ladders have been adjusted accordingly. A further cut to 1.75% of the pension base will probably follow on 1 January 2015. This has been agreed by the coalition and was recently incorporated in the Witteveen 2015 legislative proposal, which provides limits on the tax-friendly treatment of pension accrual in the Netherlands.

Pension accrual with favourable tax treatment will also only be possible for incomes of up to €100,000. For final salary schemes, the law means the maximum accrual rate will be reduced from 2% to 1.9% in 2014, and could possibly be further reduced to 1.55% in 2015.

Since 2011, premium pension institutions have been able to provide DC pensions, also on a cross-border basis. However, since the public consultation in the spring, and with all the focus on the FTK2, talk surrounding their DB counterparts – APIs – has gone quiet.

The retirement age in the second pillar will be adjusted to 67 in 2014, in line with the first pillar, the AOW, where the state pension retirement age gradually increases until it reaches the age of 67 in 2021.

After 2021, the age of retirement will automatically increase in line with life expectancy.